Covered Calls vs. Cash-Secured Puts

Here's a fact that often blows beginning options traders' minds: many options positions with different names are actually equivalent positions. It's not just a difference of nomenclature, either. These positions may be composed of totally different legs, but their net risk-reward picture ends up being identical. "Twins" of this kind are known in the options world as "synthetic equivalents".

So why have two differently composed strategies with the same-exact P&L potential? Well, these trades may be equivalent in terms of risk vs. reward, but they may differ in other significant ways: margin requirements, for example. Sometimes these small differences matter a lot when choosing your preferred strategy for the moment.

Here's an observation from the forums that illustrates this idea:

You are right they (writing covered calls and selling naked puts) are pretty much the same, I used to do a lot of covered calls, but now anything that I would have previously done a covered call on I will sell an at-the-money put, same risk , sometimes a little better premium on the option, and uses a lot less margin....

About the requirement for the naked put, the margin will increase if the stock starts moving down in value... And will decrease some as the stock appreciates in value. The actual rule for the margin is set by the CBOE and can be found on their site....

I want to correct a few misconceptions in what's stated above, but let's start with the first observation. These two strategies aren't just "pretty much the same"; they're synthetic equivalents of each other. Let's explain each strategy in turn.

Covered call "writing"- which just means "selling” - is a classic beginning options strategy. It works like this: you sell a call against long stock you already own. The number of calls you sell this way shouldn't exceed the amount of stock you own - 1 call per 100 shares of stock.

That call sale will generate cash for you - but in return for that cash, you take on an obligation. Namely, you're saying you're willing to sell your long stock at the call's strike price, if "called upon" to do so by an exercise notice. You're "covered" because you already own the stock necessary to fulfill your obligation.

Your max potential profit when the covered call is first sold is limited to the strike price, minus the current stock price, plus the premium received for selling the call. Meanwhile, your max potential risk is actually greatest on the long stock position, which could theoretically drop to zero. Covered calls also pose an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.

The comment above refers to "naked put selling", but it's clear what the writer means is cash-secured put selling. Another popular play suitable for beginning options traders, this strategy involves selling a put, for which you take in cash. In exchange for that cash, you take on an obligation to buy stock at the strike price. If you had zero cash ready to fulfill on this obligation, you'd be considered "naked". This is a super-risky move suitable only for advanced options traders. If you stash enough cash aside to cover your obligation, that's called "cash-securing" the position.

Max potential profit for cash-secured puts is limited to the premium received from selling the put. (If the puts are assigned, potential profit is changed to a “long stock” position.) Meanwhile, your max potential loss is limited to the strike price less the premium received and would occur if the stock goes to zero. (Again, if the puts are assigned, potential loss is changed to a “long stock” position.)

Now that we've examined each strategy independently, let's compare the two and consider the trader's comments above.

This trader compared selling covered calls to selling ATM puts. We can easily see how those are equivalents: each involves a block of long stock (or cash ready to be converted into long stock at a pre-set price), balanced against an options sale that brings in cash but incurs an obligation that could affect the stock or cash on reserve.

This trader mentions selling the ATM puts. The only way that can be equivalent to the covered call if you would have sold a call with the same underlying, the same strike, and the same expiration date. Remember: any little difference in these points, and you're no longer talking about equivalents.

When comparing margin requirements, don’t forget that the margin requirement to buy the shares is half of the cost of owning stock. Also, keep in mind that margin rules may be set by the SEC, but each broker is allowed to implement stricter margin rules as they see fit. Thus, it’s safer to check TradeKing's margin rules than those listed at the CBOE.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.